Arm Wrestling

In California, 30-year fixed-rate mortgages are becoming as rare as 30-year old females with real breasts – a phenomenon that bodes ill for consumer spending…if interest rates continue rising.

Already, consumer spending is showing signs of fatigue, even though the rising rate cycle is barely out of diapers. Yesterday’s headlines provided a grim preview of the spending slowdown that may lie in wait. The Commerce Department reported that retail sales, excluding auto and gasoline sales, FELL in March. Even more troubling, general merchandise store sales dropped .7%, while clothing store sales tumbled nearly 2%.

Also crossing the tape yesterday came word that Harley Davidson failed to sell as many "hogs" as anticipated last quarter, which prompted management to lower its sales forecast for the rest of the year…The stock plummeted about $10 on the news. "U.S. sales have been relatively flat with the same period last year, falling short of expectations," lamented Chief Financial Officer Jim Ziemer, "We feel it is prudent to limit short-term production growth."

Rising interest rates – it is no secret – often slow economic activity, including the economic activity of riding brand new Harley "Road Kings" off the showroom floor. But we suspect the upcoming cycle of rising rates – a cycle that appears to be underway already – will do more than SLOW activity, it might halt activity as abruptly as an oncoming tractor-trailer halts a "Road King."

Thus far, the effects of rising rates during this particular economic cycle have been more-than-offset by the ingenuity of mortgage lenders. The proliferation of adjustable-rate mortgages, and more recently, interest-only mortgages, have enabled homebuyers to buy much more home that they could otherwise afford. The resulting low mortgage payments have enabled many folks to buy more baubles and gadgets from American retailers than they could otherwise afford.

But this seeming prosperity is contingent upon interest rates behaving themselves. As rates rise, our "Ownership Society" becomes an "Income-Deficient Society" that struggles both to meet mortgage payments and to maintain consumer spending.

No surprise then the trend-setting state of California is setting the mortgage trend as well. Nearly half of all California mortgages are of the interest-only variety, up from almost none four years ago. "Confronted with soaring home prices," the Los Angeles Times reports, "Californians are adopting a ‘buy now, pay later’ strategy on a massive scale…When the price of houses in California soared 17% in 2003 and 22% in 2004, a curious thing happened: Instead of home ownership decreasing because fewer people could afford houses, it rose to record levels.

"An interest-only loan offers the ability to defer for three, five or seven years any payment for the house itself," the Times explains. "That allows a potential buyer to stretch to afford a place that otherwise would be out of reach. Of course, everyone else using an interest-only loan can stretch too. The result is that prices keep rising."

The rest of the nation is rapidly adopting California’s home-financing fashion. Adjustable-rate mortgages now account for a record-high 36.6% of all American mortgages. Therefore, as long as interest rates remain near 40-year lows, adjustable-rate mortgages will continue to provide the joy of home ownership at affordably low interest rates. However, if interest rates continue to rise, adjustable-rate financing will impart the misery of mortgage servicing at unaffordably high rates.

EZ credit terms only serve to increase the eventual risk to consumer spending. In other words, money borrowed and spent today by marginal borrowers is, at best, money that will not be spent tomorrow.

"If you can fog a mirror, you can get a home loan," a mortgage analyst recently joked. Likewise, we presume, if you can break a mirror with a beer bottle, you can get a loan to buy a Harley Davidson. Unfortunately, obtaining the loan is the easy part. Servicing the loan is more difficult, especially when rates are rising.

To illustrate the downside of ARM-financing, let’s consider the hypothetical case of Mr. and Mrs. Marginal Home-Buyer. Let’s assume the happy couple purchased their dream house in the early days of 2004 for $250,000. Let’s further assume that they acquired said dream house by using a one-year, interest-only mortgage at 3.5%, and that the resulting monthly mortgage payments consumed 35% of their combined incomes. In other words, let’s assume that they "stretched" to buy as much home the bankers would allow them to buy.

During the first year, the happy homeowners paid $729 per month to satisfy their mortgage. Unfortunately, because Alan Greenspan has raised short-term interest rates SEVEN times since the early days of 2004, the interest rate on the Marginal Home-Buyer family’s interest-only mortgage will soon "re-set" to an interest rate around 5.5%. At that rate, their monthly payments would jump to $1,145, or more than 50% of their combined monthly incomes – a burden that would be sure to make our happy homeowners very unhappy, if not utterly insolvent.

To be sure, not all holders of interest-only mortgages are skirting the edge of solvency, but we would guess that most are close enough to the edge that rising rates would force them to sharply reduce their discretionary spending.

Perhaps, as the chart above suggest, rates have risen enough already to restrain consumer spending somewhat. The blue line depicts the price trend of the Bloomberg Leisure Stock Index divided by the S&P 500. When the line was in an up-trend, stocks like Harley-Davidson and snowmobile-maker Polaris were performing better than the S&P 500. But lately, these stocks have been under-performing the S&P. The red line depicts the price trend of Harley-Davidson shares, a bellwether of consumer-spending trends. The fact that both of these price trends are sloping toward the southeast suggests that consumer spending might continue heading south.

30-year mortgages and natural breasts may both remain rare sightings in California. But neither will become extinct. Indeed, the trauma of rising interest rates in an "adjustable-rate society" may inspire a longing for a return to simpler times – a return to the days when mortgage rates were fixed for 30 years…and breasts were not.

Did You Notice…?By Dan DenningRTH is a basket of the biggest retail stocks in America. In the past, I’ve been partial to trading puts on it, because it’s the single best way to be "short the American consumer." In an era of high debts and rising interest rates, that’s nearly always a good trade…over the long term.

But in the short term, it wouldn’t be at all surprising to see the stock snap back up to $94. The two momentum indicators I’ve included on the nearby chart both show the stock being oversold…What we’re looking for soon is a way to be "short" RTH if and when the snapback rally comes. The best way is to place a limit order for an option that will decline in value as the stock rises, giving us a chance to get into a bearish trade on RTH at a good price AFTER the snapback rally.Obviously, there are several elements to the trade. If the rally does not come, then you simply won’t get filled on your trade. No risk there. In that case, you can expect to see a far larger down move in RTH, a big breakdown. A long-term put would be in order if you simply can’t wait.

And the Markets…

Wednesday

Tuesday

This week

Year-to-Date

DOW

10,404

10,508

-57

-3.5%

S&P

1,174

1,188

-7

-3.1%

NASDAQ

1,974

2,005

-25

-9.2%

10-year Treasury

4.37%

4.36%

-0.11

0.15

30-year Treasury

4.68%

4.66%

-0.08

-0.14

Russell 2000

603

613

-8

-7.5%

Gold

$429.30

$428.80

$2.60

-1.9%

Silver

$7.20

$7.18

$0.06

5.7%

CRB

300.83

302.63

-3.49

6.0%

WTI NYMEX CRUDE

$50.22

$51.86

-$3.10

15.6%

Yen (YEN/USD)

JPY 107.38

JPY 107.69

0.92

-4.7%

Dollar (USD/EUR)

$1.2910

$1.2920

18

4.8%

Dollar (USD/GBP)

$1.8934

$1.8918

-85

1.3%

The Daily Reckoning

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About Eric Fry:

Eric J. Fry, Agora Financial’s Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling. Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant’s Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant’s International and Apogee Research, institutional research products dedicated to international investment opportunities and short selling.

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts. His views and investment insights have appeared in numerous publications including Time, Barron’s, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.